Roubini's Forecasts for Asia Recovery Are Flawed

I recently saw an interview with my second favorite economist, Professor Nouriel Roubini of the Stern School of Business, New York University. The interview given for The Asset Magazine in Hong Kong at was published on line. Professor Roubini gave a superb exposition of how the present recession hurts Asian economies. His forecast was that Asian economies could recover quickly because all they have to do was to change their policies from one of investment and export to one of domestic consumer consumption. If they changed policies, then domestic demand would take up the slack from the collapse of export demand. Since Asian domestic consumers have high rates of savings, they have more than enough cash to take up the slack. This thesis has also been suggested by many other economists. It won’t work.

Professor Roubini and his colleagues did not take into consideration the Osoyoos Indians.

The Osoyoos are a tribe of Canadian Indians living in British Columbia. According to The Economist, they, like their American cousins, have built a successful business by navigating the loopholes of the antiquated Canadian Indian Act. The act, according to the article, created a “system that is increasingly outdated, expensive and unworkable.” Yet it survives. It survives because there is “an army of lawyers, consultants and bureaucrats with a vested interest in the current system”.

Changing policy any policy requires changing laws. Laws, any law, exist because there is a group with a vested interest in that law. There are many people who have made and are making large amounts of money, because of the law. If the law is changed they may lose their businesses or their advantages. As a result of their profits, they have a powerful economic incentive to retain the status quo. A recent illustration is the reaction of the hedge fund and derivatives industry at the prospect of regulation.

It is also the main problem for the Asian economies. The Asian countries need to change their policies from a policy that encourages investment and export to a policy that encourages domestic consumer consumption. For example, to make up the hole in Chinese exports, the Chinese need to encourage spending. To do so will require them to change a plethora of laws including tariffs, taxes, subsidies, and regulations etc. In addition firms, usually state owned firms, would have to change their product lines, marketing, pricing, distribution chains etc. All firms especially state owned firms in China have some degree of political power. It is far easier for them to get bailouts or subsidies and try to wait out the recession than to make the vast changes necessary.

In contrast, many Asian countries including China, do not give consumers, the main beneficiaries of a policy change, much of a voice. Better education, health care and social security might discourage savings and encourage spending by Chinese consumers, but they probably will not get it. What you have is a free rider problem. There are a few firms and individuals who have large economic incentives to maintain the system and literally billons of free riders billions who would benefit from the change. Since the firms and individuals have not only money, but by definition exceptionally close ties to the government, the present export dominated policy will remain in effect regardless of any pronouncements about social safety net spending in the stimulus package.

If you doubt this thesis, look at Japan who has had an export dominated system for almost 60 years. If you doubt the difficulty in changing laws, look at the US tax code. Every country’s laws build up vested interests. The ability of a country’s laws to limit the power of those interests is crucial to the economic efficiency of the country’s economy. Without flexible legal systems, countries cannot adapt to crisis, downturns, technological changes, and shifts in global demands that inflict financial pain. Since most of the legal systems in East Asia do not have this flexibility, changing the model has been and will be very difficult. So the rapid recovery that Professor Roubini forecasts sadly will be delayed until export markets in more developed countries recover.

Comments

[coreopsis:]

My bet's with Roubini. Gamble's position is a thinly veiled apologia for the legions of lawyers, bankers, accountants, PR people, rating agencies that he feels are necessary for the 'modern' state -- yes, indeed, for the collapse of the modern capitalist state. Hopefully Gamble will report back in 60 days.

Apr 02 12:21 PM

[inexperienced:]

I think there biggest problem would be.do they really want to let the Jeany out of the bottle.

Apr 02 01:59 PM

[Ricard:]

This article seems to think that the tail wags the dog. The argument that vested interests are strong enough to fight for "tradition" assumes that "tradition" has held up rather well during these trying times. If the foundation begins to falter, the structure built on top of it will also crumble. Those that do not adapt to such change are the ones that tend to die out in the end. I agree that Roubini's arguments have serious flaws, but not due to what Mr. Gamble points out. I'd much rather go with Bo Peng's analysis here:

seekingalpha.com/artic...

Japan is a bit of a different story than China on many fronts. They have no choice but to export. Most of what they consume is imported in the first place, so in order to balance their trade, they are forced to value-add to at least a portion of what they import in order to remain economically viable. This is not really a matter of tradition but survivial.

Apr 02 04:42 PM

[Dana H.:]

Actually, an inability to encourage the destruction of savings (which is what people mean when they speak of "encouraging domestic consumption") would be bullish for China. The Keynesian notion that a country increases its wealth by consumption, or that you can spend your way out of a recession, reverses cause and effect.

It is savings and investment, not spending and consumption, that is the engine of a country's growth. So the irony might be that the entrenched defenders of the status quo will save the "reformers" from themselves. (Of course, I am exaggerating here, as I'm sure there are numerous restrictions and regulations in China that *should* be removed in order to encourage prosperity. I am speaking here only of the issue of savings versus consumption.)

Apr 02 06:44 PM

[William Gamble:]

Savings and investment will be the engines of economic growth if the savings and investment are made to the most efficient firms. The problem export policies in Asia is that the selection of the investments have either been made directly by the government as in the case of state owned banks lending to state owned companies in China or indirectly through laws, subsidies, tariffs, or other government policies.

While this policy model has been wildly successful during the boom, unless changes, it could increase the severity and lengthen the down turn. Policy models in single party states are difficult to change because there is little incentive to do so.

Any capitalist model is only as good as the structure in which it operates. The best structure is where the legal infrastructure limits the power of the government and players. The present system failed because the legal system did not force the major players to provide sufficient information to the market to help the market correctly assess risk.

Apr 03 11:07 AM

[Maklo:]

In China, the export industry is dominated by foreign enterprises. To encourage FDI, there was a concerted effort for the past 20 years by central, provincial and municipal governments to provide tax incentives, cheap land, established infrastructure, etc. to re-locate their factories. These foreign enterprises were the usual suspects -- Taiwan, South Korea, Japan, Hong Kong etc. -- who were merely leveraging several decades of success exporting to the West. North American and European multi-nationals tended to focus instead on selling to the Chinese consumer.

While there are 100 million or so middle class (by global standards) consumers in China, the vast majority of Chinese still cannot afford the level of quality that developed economies demand. Meanwhile, the distribution channels into these consumers are complicated and difficult for outsiders to understand. As a result, this market is primarily served by domestic firms, including state-owned enterprises.

So the exporters are now coping with this huge demand destruction in developed countries for their goods. That is why factories are shutting down by the hundreds. There is obviously too much capacity in the system.

At the same time, as we speak, some of these exporters are trying to figure out how to crack into this base of Chinese consumers that they have never really tried to break into. Over-capacity leads to lower prices and lower prices means you can reach another segment of the population heretofore unreachable. So one impact I would predict is that some of these exporters break into new markets in China.

Meanwhile, domestic manufacturers have been steadily improving their production methods, quality, processes, etc. They are learning from their competitors - a natural component of capitalism. And now they are seeing more competition trying to break into their markets, so they need to also "step it up".

Eventually, there will be less of a distinction between domestic firms and foreign export-oriented firms. There are clearly signs of that today with domestic firms like Haier and TCL breaking into overseas markets, as well as foreign brands making further inroads into China's hinterlands. But overall, the implications for both the domestic and foreign firms in China are to adapt or die. And I would predict that some will adapt and some will die, with the net result being ... more competitive survivors, better quality and overall improvement in living standards for the vast majority of Chinese and a net reduction in the demand destruction from the developed countries.

I am not arguing that there will not be short-term pain. The shutting down of thousands of factories is clear evidence of that. I am arguing that policies might change, but China's economic development path is going to continue forging ahead in pretty much the same trajectory as before.

There is significant evidence that the Chinese habit of favoring state-owned enterprises is decreasing. This makes sense, as the SOEs make up an increasingly smaller share of production and employment (twenty years ago it was 80%+, today it is less than 50%). Recent government actions included more available bank lending for exporters and other private sector firms. The rules and laws around property ownership were re-vamped in the last couple years to make it easier for individuals and businesses to own land. The establishment of national social security and healthcare plans are top of the agenda for the government, which should ease the need to save and encourage more domestic consumption.

Apr 03 05:17 PM

[William Gamble:]

"There is significant evidence that the Chinese habit of favoring state-owned enterprises is decreasing."

This is an interesting point. I have seen numerous numbers regarding this. My real question is how do you know? As I wrote in an earlier article government corporate records are not always available and not always correct. It is very easy to hide the true ownership of a corporation. A recent study showed that one of the easiest places to incorporate with little or no information about the true owner is Wyoming!

Chinese state owned companies also come in many different forms depending on the level of state ownership. Anything from a village to the central government. Then there are agencies.

So the reality is that with out protected speech, free access to government records, there actually is no way to tell which companies. My guess is that without sufficient legal disincentives there is no real economic reason to assume that either the number of state owned firms has diminished. The size of the shadow banking system also suggests that the state owned banks are still lending to only state owned industries.

To the best of my knowledge, no one owns land. You can lease property for long term leases, but the state is the only entity that actually owns land.

Like all governments, the Chinese government can promise anything. Governments in democratic countries usually have some incentive to do something about it. They have an incentive. If they don't solve the problem, they will not get reelected. It is hardly surprising that the establishment of national social security and healthcare plans are top of the agenda for the government. Actually doing something about it, is something quite different. Why should they?

Apr 06 04:41 PM

[nsnandra:]

There is a reason why savings rates are high. People aren't going to change in a hurry. So the desired domestic consumption binge is unlikely.

Apr 10 09:22 PM

[Maklo:]

William - land ownership policy in China under long-term leases is not dissimilar from the system in Hong Kong or the U.K. Even here in the U.S., you only "own" the land as long as you can afford the property taxes.

Suggesting that *only* democratically elected governments have incentive to work for the people or that only with free and protected speech can you lend any credence to the numbers ... is idealogical and blinds one to reality.

Apr 13 12:05 AM